Diversity Matters

Much of the draw surrounding bitcoin comes from the potential to make a lot of money for relatively little work. The timeless desire of humans to take a shortcut to success is preyed upon by a technical innovation that claims to jump the waiting line, to bridge societal inequality, and offer believers a quick route to riches. Of course, like everything in life, and especially investing, returns are coupled with risk. The amount of risk, defined as the potential for loss, assumed by speculators in bitcoin is massive. Hacks, regulation, fraud, volatility, the list goes on. An astute money manager knows that diversifying their portfolio is a robust way to mitigate risk, spreading the potential for loss and gain across many bets. In the cryptocurrency world, this has proven to be very difficult.

In investing, which I maintain bitcoin is not an investment but rather a speculation, beta is volatility relative to the market. For instance, if the market for cryptocurrencies went up 5% and bitcoin went up 5%, we would say bitcoin has a beta of 1.0. A beta of 1.3 would mean an asset has volatility 30% greater than the broader market. This is a measure intended to capture the nuanced investing measurement of not simply volatility, but volatility above the mean. This is an important distinction because a speculator can simply buy some of all assets to mirror the market, capturing the returns and risk of a large market. Investments, therefore, should be identified based on their movement relative to the market as a whole, since the investor is making a decision to assume more or less risk to match their appetite and ambition.

This is a problem for digital assets so far, as bitcoin appears to control all other assets. Because there are significant hurdles for converting digital assets to fiat currencies, pesky things like federal governments and AML/KYC, and fraud and illiquid exchanges, money spent acquiring cryptocurrency is often locked in the digital world. Not to worry, you may say, the free market possesses an abundance of new coins and assets! Well, yes and no. The explosion of ICOs is basically an explosion of scams and Ponzi schemes marketed to a captive audience, looking to capture more liquid and exchangeable assets like bitcoin and litecoin for completely made up assets. This can appear to be a win-win as holders of bitcoin seek diversification to achieve the goal of mitigating risk in the crypto space. Unfortunately, the evidence suggests that diversifying among cryptocurrencies doesn’t actually achieve risk reduction.

Pleasurable graphs and charts produced by bitcoin believers often display a positive trend, bitcoin is going up! Only up! Other graphs show the volatility of bitcoin, and overlaying the prices of many other digital assets clearly demonstrates the informal peg that exists (Credit) between them. Sites like CoinMarketCap do a pretty good job of capturing this information for all to see, and though previous performance does not dictate future performance, the trend is clear that bitcoin runs the cryptocurrency world. This should be a red flag for users and speculators, as their opportunity to hold and profit from many assets within this class is actually not related to single coins, but rather the larger trend. There is little to no rational incentive for long term holding of coins other than bitcoin, as the returns will be similar regardless.

This finding supports the advice I have given from the start to friends and readers who inquire. Bitcoin and cryptocurrency seem to be a smash and grab situation, where returns are fleeting and timing is key. This is poor advice for value-based investors or any legitimate investor that wants a stable asset. This volatility and shared risk is great for day traders and young, unhindered traders who don’t feel the weight of their mortgage, impending retirement, or familial needs. It is also great for exchanges who can manipulate prices to liquidate positions to benefit their bottom line, and whales who appear to do the same. What’s wrong with digital assets? Nothing. Unless you’re a normal person with a desire for stability and limited risk. Sounds boring to me.

Image credit – Public domain image by Satoshi (Source)